Tax Time! Keep Your 1099 Audit-Free

For independent IT pros, it’s about that time of year again. Yeah, that’s right: tax time. This is when you get to sit down and pore over stacks of boring paperwork for hours, all for the purpose of sending your money to fund federal projects like a bike trail in Hot Springs, Ark., or research on olive fruitflies (and these are actually some of the more useful ones).

The worst part about all this for IT contractors who operate a sole proprietorship isn’t the fact that they have to pay taxes, though. Some of that money actually does some good, after all. No, the worst part is the fact that they file 1099 forms. IT pros who don’t work full-time for a single employer, but rather work with various clients on a contract basis, must file a 1099 for every single customer they serve. Obviously, if you have a lot of clients, this can complicate things.

Also, the fact that 1099s are several times more likely to be audited than W-2s doesn’t help at all. This is due to a couple of factors. Professionals might claim questionable deductions, or ones that merely seem questionable from the standpoint of auditors. (For more on what you can and can’t deduct, see www.irs.gov/pub/irs-pdf/p535.pdf.) Suffice to say, be prepared to defend the vocational relevancy of your deductions.

Additionally, the sheer volume of paperwork, especially for an independent with a significant clientele, can increase the chances of a clerical error somewhere. You can get penalized for that stuff too. Financial penalties for mistakes won’t apply if the failure to file was due to a reasonable cause or is an inconsequential error. But remember: What you think is an insignificant mistake might be completely different what the IRS thinks. For example, blunders like an incorrect tax identification number (TIN), a misspelling of your name or an error in income amounts are always noteworthy to the feds. Make sure to edit and re-edit your work, and try to get another set of eyeballs (someone you know and trust, obviously) to take a look at your forms.

Also, remember to file for anyone you have paid to help you out with a project on a contract basis. Income for fellow independents or freelancers who assist you temporarily must be reported via the IRS’ 1099-MISC form. These have to be issued to any person that you have paid at least $600 in rents, services or other income payments. You can order forms from the IRS by calling 1-800-tax-form or ordering them off of the IRS Web site, which typically take at least two weeks to be delivered, but may take longer. If you need the forms sooner, you usually can find them at libraries and post offices.

All of this can be frustrating for independents, who can lose some serious productivity from the considerable amounts of time and effort they have to put into all those forms. Therefore, many of them have opted to skip the headaches involved with that paperwork, as well as the concerns that come with having to make sure everything is just right. They save time and keep their 1099s out of the audit pile by simply not filing 1099s—that is, they join an association of contractors and attain W-2-filing status.

There’s another reason more and more independents are avoiding 1099s: Most larger companies will not pay anybody under a 1099. Under current regulations, the IRS puts a huge burden on the paying company, so if they think that the contractors can be classified as employees, the organization will be penalized more than twice the retroactive payroll taxes. Thus, big enterprises will make contractors to go through a corporation, whether it’s their own, a staffing company or a loose association of independents.

There are essentially three different arrangements IT independents can go for to file W-2s instead of 1099s. There is the S corporation, which is basically an umbrella organization of smaller outfits, which allows for simpler individual tax filings and record-keeping. There also are limited liability corporations and partnerships, which, while different in a business sense, are very similar to S corporations in terms of taxation. Finally, there are journeymen who work for organizations that send them from place to place, much like a staffing company.

This isn’t to say that operating as a true independent and filing a 1099 is all bad, or that joining a contractor association and filing a W-2 is all good. There are certain tax advantages derived from the former situation that wouldn’t be available to those in the latter. After you’ve filed this year and seen what your returns were, what you could write off and what you couldn’t, and how much time you spent on paperwork, assess your situation and make sure that you’re maximizing your time and capital. You owe it to yourself—after all, you are your business.